The government has announced a big fiscal stimulus package. In addition, RBI has taken further steps to reduce interest rates and raise liquidity in the economy. This adds to the number of steps the RBI has already taken to ensure adequate rupee liquidity. However, the contribution that domestic monetary policy can make in averting the slowdown is limited. Apart from the tax cuts which will have immediate impact, fiscal policy is limited not only by the size of the deficit, but even more by the capacity of the government to spend quickly.

The standard macroeconomic policy recipe for a country that faces a downturn is to ease monetary policy by cutting interest rates and to ease fiscal policy by spending more and taxing less. There are many problems with this recipe in the present Indian context. By and large, RBI has done the right things in terms of ensuring adequate rupee liquidity. From mid-October onwards, RBI has come up with a slew of responses, some unorthodox, which have delivered a call money rate which is within its ‘LAF corridor’ and driven down the short-term interest rate in the economy. The speed and size of RBI’s responses have pleasantly surprised the private sector and shown India in good light.

If RBI had made mistakes, and the call rate had persisted at 20 per cent, a financial crisis in private banks and mutual funds would have come about. This has been forestalled. But when RBI cuts rates, the positive impact upon the economy is limited. India lacks the ‘Bond-Currency-Derivatives (BCD) Nexus’. As we have seen in recent weeks with bank lending rates not coming down, the mechanism through which changes in the policy rate impact other interest rates in the economy. As a consequence, the effectiveness of monetary policy is limited. RBI can and should continue to cut rates, but this does not imply that a lot of interest rates across the economy will necessarily go down in proportion.

... contd.